3 ways to save for your child's future

• Christina Couch
• On 6:00 am EDT, Monday October 19, 2009

Opening a savings account in a child's name may seem like a great way to give Junior a head start on a lifetime of thrift. However, it can come back to haunt families, especially when college years roll around.

In fact, choosing the wrong savings vehicle for your children's future cash could cost them thousands in avoidable taxes and missed financial aid.

"In the federal formula that determines how much financial aid a student receives, there are asset protections for money in a parent's name that are not there for money in a student's name," says Robert Helgeson, director of financial aid for Valparaiso University in Indiana."If a parent has $100,000 in assets, the government is going to expect them to contribute $6,000 of it to education. If a student has $100,000 in assets, the government will expect $20,000."

Students can have up to $3,000 stashed away in a checking or savings account in their name without losing any financial aid, according to the U.S. Department of Education.

However, for every dollar above that threshold, 20 cents is subtracted -- first from federally funded scholarships and grants the student would have been eligible for, then from federally funded loans.

Because financial aid is determined based on income and assets from the year prior to applying for aid -- in most cases, the student's junior year in high school -- students with large amounts of savings in their name could end up losing a hefty sum of free college cash.

Fortunately, there are several ways for parents to save that will not put their child's future financial aid at risk. The following are three places to safely stash the cash:

529 college plans

One popular method is to save for college through a college savings plan.

Operating similar to IRA and 401(k) plans, 529 college savings plans allow parents to save for a child's education tax-free through an array of investment options. Some age-based investment packages place funds in aggressive investments when the child is young, then automatically switch funds to more stable options as the child approaches college age.

These plans offer major tax advantages, says Craig Parkin, director of institutional client services for TIAA-CREF Tuition Financing, the investment organization that administers Kentucky's state-sponsored college savings plans.

"The gains on the accounts are tax-deferred, and once the funds are used to pay for qualified tuition expenses, parents will never pay taxes on those funds," he says.

Money in these accounts can be used for undergraduate or graduate studies at any accredited two- or four-year campus in the United States. Savings in a 529 plan belong to the parent, not the child.

"A 529 college savings plan is considered a parent's asset because the parent is the account owner and they can change who the beneficiary is," Parkin says.

Kelly Campbell, a Certified Financial Planner and founder of Campbell Wealth Management in Fairfax, Va., cites another advantage of these plans.

"An additional benefit with a 529 plan is that if the child says they don't want to go to college, the parents or whoever owns the account can change the beneficiary," Campbell says. "That way, you know the money will be used for education. They can't just take it and run."

While 529 savings plans offer big advantages, they also come with a few restrictions. According to the U.S. Securities and Exchange Commission Web site, 529 college savings funds can only be pulled out tax-free for qualified education expenses, including tuition, books, fees, supplies, and room and board. Money spent on unqualified expenses is subject to income tax and a 10 percent penalty on earnings.

There are also restrictions on how money in these plans can be invested.

"With 529 plans, (plan holders) don't have a lot of control over their investment options and can only change their plan once a year," says Matthew Havens, a Certified Financial Planner and partner at Global Vision Advisors in Hingham, Mass. "If your investment philosophy doesn't fit into the options they offer, a 529 plan can feel like handcuffs."

A prepaid tuition plan is an alternative to a 529 savings plan that may appeal to some parents. Designed for parents who are sure that their child will attend an in-state public school, these plans allow parents to simply purchase tuition credits in advance at today's prices.

Prepaid 529 plans retain the same tax, financial aid and parental protections as 529 college savings plans, but without being subject to ups and downs of the stock market.

"The major limitation to a prepaid plan is that if the child decides to go to school out of state, they'll get a return on their money, but they won't get the full value of the plan," says Parkin. "For example, if someone bought one year of tuition at a Kentucky state school for $12,000 and now tuition is up to $20,000, they would get a full year of college. If they decide to go to school in, say, Ohio, they would get a return -- probably $13,000 or $14,000 -- but they wouldn't get the full $20,000."

Like 529 college savings plans, prepaid plan holders can change beneficiaries at any time, but must pay a 10 percent penalty plus income tax on funds used for anything other than college tuition.

"You can have the prepaid plan to pay for tuition and a 529 college savings to pay for other expenses," says Parkin.

UGMA and UTMA accounts

If the child doesn't plan to attend college and therefore isn't at risk of losing financial aid, UGMA and UTMA custodial accounts offer decent tax breaks for children under the age of 18.

In these accounts, the first $950 in gains is tax-free, the second $950 is taxed at the child's income tax rate and the remainder is taxed at the parent's income tax rate, according to the IRS. Plus, there are no restrictions on how the funds may be used so long as it directly benefits the child.

The downside of UGMA and UTMA accounts is that parents have less control over how the child eventually spends the money, says Michael Kay, a Certified Financial Planner and president of Financial Focus, a financial planning firm in Livingston, N.J.

"If money is in a UTMA or a UGMA account, it becomes (the beneficiary's) at the age of majority, which is 18 to 21 depending on the state," he says. "There's no legal way to prevent the child from using money that was intended for college or a house to go to Europe."

Roth IRA

Finally, parents can give their kids a financial head start by opening a Roth IRA in the child's name once the child starts earning income, Havens says.

"If the child has an earned income, a Roth IRA is a great way to start saving a nest egg for a first house or for their retirement since the assets grow tax-free," he says.

While children over the age of 18 retain control of the account, restrictions on Roth IRA withdrawals prevent investors from taking earnings out penalty-free until the age of 59�.

However, there are exceptions to this rule that allow early withdrawals due to certain circumstances (hardships such as a disability) or for certain types of spending (such as purchasing a first home or for qualified education expenses).

A trust in the child's name is another option for parents concerned about how their kid will blow the dough. However, these plans come with legal and administrative fees parents won't encounter with a Roth IRA.

Common mistakes

Meanwhile, some parents may believe that it makes more sense not to save at all for their child's future. The idea is that having no college savings also means having no assets to assess.

However, Helgeson says that strategy won't work.

"When the federal government decides what a family's expected contribution is, most of that number is based on the parent's income," he says. "Even if parents don't save anything, they're still going to have an expected contribution."

Another common mistake is for parents to save for their children's future before addressing their own long-term financial circumstances, Haven says.

"The worst thing parents can do is not set themselves up and become a burden for their kids later," Haven says. "It's not about sacrificing one goal for another. It's about looking at all of their goals at once and deciding the best way to tackle them as a whole."